Investing Guide at Deep Blue Group Publications LLC Tokyo: How Much Will You Earn On Your Stocks And Bonds?

Are retail
investors’ expectations upside down–high when conditions are bad for
investing, low when conditions are good? Is there a better way to anticipate
what’s going to happen to your retirement savings?

Our answers: yes and yes.

There is ample evidence that popular expectations for
investment returns are just about the opposite of what would come from a sober
analysis of the fundamental data. In 2000, when the market was trading at
absurdly high multiples of corporate
earnings, funds holding U.S. stocks hauled in $288 billion. In 2002, when
stocks were cheap, the inflow slowed to a $13 billion trickle.

The inflow into stock
funds dried up once again after the crash of 2007-09 and stayed low for
most of the next five years. Now, with stock prices at abnormally high
multiples of earnings, the investing masses are putting big money into stock
funds.

It’s the same with junk bonds. A rational investor would
be most likely to buy risky
corporate debt when the reward–the yield–is highest and least likely when
it is meager. The public is doing just the opposite.

In tumultuous 2008, when junk bond prices were depressed,
their yields averaged a 10% premium over safe Treasury paper. That was a good
time to be buying. But retail investors were doing more selling than buying.
That year junk funds saw $6 billion of net redemptions, not counting
reinvestment of dividends, according to data from the Investment Company
Institute.

Six years later the prices of risky bonds have recovered,
and their yields are correspondingly lower. What are investors doing? They
should be selling, but they are not. In 2013, when the yield premium on average
was only half that of 2008, investors poured a net $54 billion into junk funds.
The money is still coming in ($10 billion in the first four months of this
year).

The pattern: If an asset class has done well recently,
making its price high, fund buyers want it. If it has done poorly, making it a
bargain, they want to sell.

The phenomenon described above anecdotally has been
studied statistically. Two Harvard professors, Andrei Shleifer and Robin
Greenwood, published a paper last year demonstrating that investor expectations
are highest when objective models would say that expected asset returns are
lowest, and vice versa.

“People react to salience,” says professor Greenwood.
“Recent performance is salient.” That’s a polite way of saying that naive
investors navigate with a rearview mirror.

You don’t have to make that mistake. There are better
ways to come up with a forecast of future returns than to extrapolate the
recent past. We’ll explore some formulas for stocks, bonds and the funds that
own these things.

Experts can differ about how to come up with an expected
return from an asset. But one thing they would agree on is that recent
performance is a bad indicator of future results. You shouldn’t be buying an
asset class because it has been going up.

The place to start is with the yield. For a bond, it’s
the interest yield. For a stock, it’s the earnings yield, which is the net income
divided by the stock price.

Next, investing costs have to be figured in–both the
management fees and the cost impact of turning over a portfolio. If you are
buying bonds, you have to allow for inflation. (Shares of stock, in contrast,
are not impacted the same way because corporate earnings tend to keep up with
inflation.) It’s just possible that 401(k) savers don’t pay much attention to
these things.

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When they were newlyweds 23 years ago Jeff
Maggioncalda’s wife, Anne, challenged him to a Monopoly battle. Determined to
gain the upper hand, Jeff secretly created a program, known as a simulation
engine, to model the results of 1 million Monopoly games and used it to
generate a list of probabilities and payoffs for all the game’s properties. “We
played until she realized I had this little cheat sheet, and then she thought I
was a total jerk,” he laughs. (Actually, Anne, whose Ph.D. dissertation was on
the reproductive strategies of male orangutans, was amused by his creative
adaptation.)

Maggioncalda, 45, has used his knack for
simulations (and for landing on the corporate equivalent of Boardwalk) to win
at a real-life game, too: the financial
advice business. As chief executive of Financial Engines FNGN -0.48% he has
built the nation’s largest registered investment advisor, with (as of Mar. 31)
$92 billion in 401(k) assets under management for nearly 800,000 workers of 553
big employers, including Alcoa AA +0.88%, Dow Corning GLW +1.01%, Ford, IBM IBM
+0.99% and Microsoft MSFT +0.14%.

Savers pay Financial Engines from 0.2% to 0.6%
of their 401(k) assets annually to manage their nest eggs based on modern
portfolio theory, which aims to maximize the return for a given level of risk.
Its computers run thousands of scenarios (known as a Monte Carlo simulation) to
give each worker a picture of how much retirement income he or she is likely to
have, and use an “optimization engine” to determine the best portfolio given
the costs, quality and styles of the mutual funds available in each 401(k), with
a preference for low-cost index funds. Clients can consult with humans manning
call centers, but the advice they’ll get comes from the computer models. (For
two examples of Financial Engines’ portfolio makeovers, see below.)

Now, with its baby boomer clients edging toward
and past 60, Financial Engines is angling to grab a piece of another
potentially big business: managing assets and income payouts for retirees.

“Retirement income … it’s a really hard problem.
You’re looking at a 30-dimension probability distribution,” observes
Nobel-winning economist William F. Sharpe, a cofounder of Financial Engines.
While Maggioncalda’s entrepreneurial energy has built Financial Engines, the
80-year-old Sharpe, who won the Nobel in 1990 for his work on the pricing of
financial assets and the relationship between risk and return, is at its
intellectual core.

Back in 1996 Sharpe was offering asset
allocation software he’d developed on his website for free–to, as he puts it,
“give ordinary people the tools to think probabilistically about their
investments.” But during a long lunch at Stanford University’s student union,
Joseph Grundfest, a Stanford Law professor and former member of the Securities
& Exchange Commission, persuaded him that he’d make a bigger impact with a
for-profit business. “If we’re serious about changing how people behave in the
real world, we’re going to need to start a company,” Grundfest told Sharpe over
a second cup of coffee.

The two academics, along with the late Craig W.
Johnson, an attorney who took equity positions in startups, seeded Financial
Engines, and Grundfest went hunting for someone to run it. “You needed a
candidate who could have an intelligent conversation about modern portfolio
theory with Bill Sharpe. Right away your pool of candidates gets cut down by
99%,” he says. Grundfest settled on Maggioncalda, then a 27-year-old newly
minted Stanford M.B.A. who had written a prescient case study about how the
Internet could disrupt the stock brokerage business for a class taught by Intel
founder Andy Grove. The three older men hired Maggioncalda to write a business
plan and promised to eventually make him CEO–if he could raise the venture
capital to build the business. “At that time the idea of a 27-year-old CEO in
Silicon Valley wasn’t broadly accepted. Today, at 27, you’re washed up,” muses
Grundfest, now 62. Continue
reading…

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But in the modern era, there is little person-to-person
about it.; borrowers work with institutions who have all the power; terms can
sometimes be oppressive.

The Internet is leveling the playing field. Online peer-to-peer (P2P) lending platforms
are doing away with the banks that act as slow-moving, costly intermediaries,
bringing pools of borrowers together with individual investors. For professional investment managers, the
result is an alternative—and attractive—income asset class. (Why do I say
attractive? See my personal experience and returns with one such platform
below.)

Tom Myers, a San Francisco-based principal at the wealth advisory
firm Brownson, Rehmus & Foxworth, was an early adopter of P2P lending. With
one of his clients on the board of Lending Club, the largest of the P2P
platforms, Myers opened up a personal account. The more he looked under the
hood, the more he liked what he saw as an option for some of his high-net-worth
clients. Five years later, Myers now has about $75 million of client funds
invested in the LC Advisors Fund, a professionally managed pool. “There’s
decent return for some modest risk for the kind of clientele [average
investable assets of $20 million] we serve,” he says.

Chris Spence of Picayune, Miss.-based Diligentia LLC is
such a champion of P2P lending that he established his investment firm partly
to exploit the advantages of investing in it, as well as other nontraditional
asset classes. The value proposition Diligentia offers clients is also
nontraditional: Clients receive a guaranteed rate of return. Diligentia profits
represent the spread between its net annualized returns and the guaranteed
payments to clients. Spence’s firm reserves the right to invest clients’ funds
in a variety of asset classes including, but not limited to, equity
instruments, debt instruments, ETFs, real estate and, increasingly, P2P
lending.

Spence started using Lending Club on a personal level in
2010 and quickly became a power user. “Once I got comfortable enough with P2P
lending, I took an incremental approach in bringing in Diligentia assets,” he
says. “I’ve been pleased by the net annualized returns. Both (Lending Club and
Prosper) do a good job pricing their loans,” he adds, and the platform’s
backtested results show accurate estimations of defaults.

Marketplace
Lending

Indeed, so popular is P2P lending among the professional
investment classes that some of the peerness is coming out of the process. The
influx of funds is less from individuals and more from hedge funds, family
offices and other institutions seeking to park private capital. Although I’ll
continue to refer to it as “P2P lending,” perhaps “marketplace lending” better
reflects the emerging reality.

Regardless, for investors, the best thing about P2P
investing is how easy it is. There are few barriers to entry; you can get
started for as little as $25. The platforms offer wide options for investors
wherever they are on the risk-aversity curve. For conservative investors who
want to supplement their CDs, the least risky notes on the platforms offer
substantially better returns than bank certificates for modestly higher risk.
For investors who want to complement their junk-bond portfolio, there are notes
with correspondingly higher risk profiles. “I’ve never felt more confident in
the stability of the asset class,” Spence says. “P2P is coming into the
mainstream.” Lending Club has filed with the SEC to go public later this year.

Jeffrey S. Buck, an Atlanta-based principal and member of
the investment team at Diversified Trust, thinks of P2P investing as an
alternative to traditional fixed income. For receptive clients, he typically
targets 5 to 8 percent of a client’s portfolio, often shifting money from
lower-return, credit-sensitive bonds. While liquidity exists, Buck nevertheless
counsels his clients to think of these assets as a five-year hold. “A key
benefit offered by P2P diversification is that it has a low correlation to
other asset classes in their portfolios,” he says.

Buck and the investment team at Diversified Trust
analyzed P2P strategy until they had a good understanding of the expected risks
and returns. “Reaction from our clients has been positive; some clients who had
been receiving monthly distributions have recently elected to reinvest
instead,” Buck says. “With rates low and expected to go sideways or higher, P2P
is an attractive income alternative and diversifier to traditional bond
strategies.”

“In the spring of 2013, Lending Club began experiencing a
huge surge in investor interest from a diverse group,” says Bo Brustkern,
co-founder of Lend Academy Investments, a service established specifically to
help advisors and family offices invest in established and emerging P2P
platforms. “Since then, Lending Club has been oversubscribed, and as a result
it has restricted allocations to virtually everyone, including many family
offices and advisors. While Lending Club attempts to catch up with demand, the
situation today is that many large investors are still significantly delayed in
putting their money to work. Eventually, we believe the marketplace will
re-establish equilibrium,” he says.

P2P in Operation

Online platforms such as Lending Club and Prosper
Marketplace match lenders with borrowers of varying credit risks, offering net
annualized returns of around 8 to 20 percent. Investors usually take fractional
shares of large numbers of notes to mitigate risk of defaults. Both platforms
provide profiles of the creditworthiness of the borrowers and the performance
characteristics over time of the notes they issue. The platforms then offer the
notes in what is essentially an auction. Once a note attracts a sufficient
number of investors, the loan is originated and serviced. Platforms charge
borrowers a one-time fee and lenders a monthly service fee.

P2P loans are typically funded by specific individuals
lending their own money on a fractional basis at interest to specific
borrowers. For example, a note of $1,000 to a specific borrower is often funded
by $25 investments from 40 different lenders. As borrowers repay the 36- or
60-month notes, the principal and interest payments are distributed
proportionally to the individual lenders. Lending Club loans are
$1,000-$35,000; the average is $13,913. All notes are unsecured.

Lending Club has some rigid underwriting standards. It
rejects applicants with FICO scores lower than 660 and a debt-to-income ratio
below 30 percent, a set of thresholds that is said to exclude over 80 percent
of applicants.

Interest rates are a function of the calculated risk that
the borrower won’t repay the loan. The higher the anticipated rate of default,
the higher the interest rate the borrower pays and the lender can expect.
Lending Club groups borrowers into seven loan grades, A through G. Within each
loan grade borrowers are further categorized into five sub-grades, 1 through 5.
The most credit-worthy borrowers are graded A1, the least worthy G5. Where
applicants fall on that risk continuum depends on Lending Club’s assessment of
their credit history. Applicants graded A1 get to borrow money at the lowest
rates, currently 6.78 percent APR for 36-month notes and 7.3 percent for
60-month notes. For borrowers rated G5, the rates are, respectively, 29.99 and
28.69 percent APR. Prosper charges even higher rates for borrowers with lower
credit histories.

More than three-quarters of borrowers list debt
consolidation as the purpose for their loans. So it’s a no-brainer for them to
borrow at, say, 11 percent from a P2P lender to retire credit card debt of 21
percent or more. Other purposes for loans include home remodeling, vehicle
purchases, medical costs and even vacations. Of course, there is no guarantee
that borrowed funds will be used for the listed purpose.

One-Year In: My
Experience with Lending Club

To better understand P2P investing, I opened a Lending
Club account in April 2013. Initially, I deposited just $275 and carefully
selected 11 of the most conservative, lowest-interest-bearing A and B notes I
could find. Like most fledgling investors, I dreaded defaults. Within 45 days,
I started receiving daily interest and principal payments that totaled $8.46
per month, which represented a net annualized return of 9 percent. After a few
months of receiving such returns, I considered that my savings accounts paid
interest of 0.25 percent and my three-year CDs paid 1.5 percent. The more I
researched this article, the more comfortable I got with P2P. In the following
months, I began transferring idle cash to my Lending Club account, first
gradually, then more aggressively.

Returns are gratifying and immediate. My Lending Club
notes outperformed not only all my other self-directed investments, but all of
the respectable returns my investment advisor harvested on my behalf in my
retirement accounts.

Spending time on the platform, I saw that most savvy
investors preferred the highest-yielding notes. In fact, there’s intense
competition for the most desirable notes. Historical data seems to bear this
out. The significantly higher yields (as high as 15 to 25 percent) seem to more
than compensate for the very real increase in predicted defaults. My own
tolerance for defaults increased.

A Random Walk Through
Peer-to-Peer Lending

When I started, I wanted to see if my careful selection
of notes would outperform notes selected at random. As an experiment, I created
a diversified portfolio of 250 notes I individually selected, one by one. At
the same time, I created another portfolio filled by an equal number of notes
selected at random. To this point, I can report that I’ve found no significant
difference in performance.

A number of services insist they have a better way to
filter out and select the best-performing notes (see sidebar). But Renaud
Laplanche, the CEO of Lending Club, insists that no loan is “better” than any
other. “There is no evidence that any investor has generated
better-than-average returns on the platform consistently,” he says. “[Advisors]
can tailor their portfolios based on their risk appetite and objectives, but
that doesn’t have a negative impact on the other investors.”

Fifteen months after starting this experiment, my account
had slightly more than 4,000 notes of every risk threshold (see Figure 1). I’m
only about halfway through the lifecycle of the 36-month notes and even earlier
for the 60-month notes. Defaults, if they happen, tend to occur later in the
process. Still, as I filed this article, I had only two notes go into default.
Of course, 69 notes are in various stages of arrears and many of these will
almost certainly be charged off. Interest from P2P loans is generally taxed as
personal income instead of capital gains.

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Motley Fool - We’re now four days into the
new financial year – the ASX having delivered a
17.4% return, including dividends over the past twelve months. Added to the
prior year’s gain, an investor who achieved the market average return has seen
their wealth swell by 44% in 24 months.

It’s almost – almost – enough to
make you forget about the pain and anguish of the GFC. Certainly markets are in
an optimistic mood – new floats seem to be hitting the market almost every
week, and companies are wheeling and dealing in ever greater numbers, with
merger and acquisition activity hitting levels not seen since last millennium.

And that’s reflected in the
market’s mood.

From
euphoria to pessimism and back

Two years ago, bad news was
terrible, good news was bad and great news earned a shrug of the shoulders.
Greece was going to hell in a handbasket, the US was in an intractable
recession and the mining bust was going to be the end of us.

These days, the share market has
hardly noticed Ukraine, Iraq, slowing Chinese growth or tepid corporate profit
growth – it’s full steam ahead for investors, who’ve enjoyed that almost 50%
two-year gain and are in a significantly happier mood.

The market is a moody and
unpredictable beast… except that its moodiness is completely predictable! No,
you can’t forecast when, or by how much the market will overshoot, but it
always does, in both directions, as sure as night follows day.

Which of those two periods were
right? The ‘endless winter’ or the ‘everything is wonderful’ phase? Probably
neither – things are never so bad, or so good, as we imagine.

So as we head into this new
financial year, here are some things to keep in mind.

Be prepared

There will be many predictions
made. Remember
that doom and gloom sells, so those are the ones that’ll be given the biggest
headlines and the highest rotation on the business news. And for every prediction of
doom, there’ll be a prediction of a boom. Ignore them… the success rate of
pundits tends to be indistinguishable from a coin toss.

Forecasters always group around
the average. You don’t
lose your job for guessing that the market will return about average. If you’re
wrong, at least you’ll have plenty of company. Being outlandish is never a good
career move. But there’s a corollary:

Beware the forecaster who has
nothing to lose. Eventually,
he or she will guess right, then dine out on that (and earn a lot of money on
the speaking circuit) for many years. In the meantime, they’ll be spectacularly
wrong.

It’s a rare market that moves in
a straight line in either direction. “The trend is your
friend”, they say. That’s true… until it ends.

The laws of gravity don’t always
apply to financial markets.
What goes up can keep going up… but not necessarily. Looking for trends and
patterns can be dangerous.

It’s always easy to explain what
the market is doing… in hindsight. The future is never so clear, and the things that make the market
jump or slump are usually from left field anyway. And finally…

Never, ever fall for the trap of
believing that the market is efficient and rational. If it were, the GFC would never
have happened, nor would the tech boom. Booms and busts happen precisely
because the market is irrational.

Foolish takeaway

The stock market can seem scary,
unfathomable, difficult and stacked against you. There are many ‘helpers’
who’ll only too happily reinforce those notions then offer to help you… for a
hefty fee.

Despite assumptions to the
contrary, successful investing hasn’t been helped by the internet, lower
brokerage and a deluge of data and opinions. There’s a reason Warren Buffett
moved from New York to his hometown of Omaha, Nebraska, and doesn’t have a
computer on his desk!

Successful investing is buying
quality businesses at attractive prices, then letting management do its work,
only selling when you lose faith in the company or the shares are significantly
overvalued. It’s simple, but it’s not easy, so controlling your temperament
should be your New Financial Year resolution.

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Investing Guide at Deep Blue Group Publications LLC Tokyo: Winning An Insiders' Game In Stocks

Buy stocks
that are getting scarce–their price is likely to go up. That quirky strategy is
behind AdvisorShares TrimTabs Float Shrink (TTFS), an exchange-traded fund that
invests in companies creating a share
scarcity of sorts by buying in their own stock. In the philosophy of Charles
Biderman, founder and chairman of TrimTabs Investment Research, prices on Wall
Street are a function not so much of earnings as of supply and demand.

That
philosophy would be somewhat jarring to a student of corporate finance. Indeed, a classic
theorem says that, in the absence of real-world frictions, a corporation
neither helps nor hurts its shareholders when it buys and sells shares, borrows
money or pays a dividend.

As for
shares going up because they are in short supply, the finance professor might
well ask Biderman: How could there be a scarcity of something that can be
manufactured with a mouse click? Corporations can issue more shares whenever
they feel like it.

They can,
but they don’t. If a company like Apple AAPL +0.04% or 3M MMM +0.08% is buying
its own shares in the open market, Biderman says, it’s more likely than not
that the insiders expect good things from the business. TrimTabs owns both of
those stocks.

If Twitter
TWTR +1.74% or Alibaba is selling shares in a public offering, that could be
because the smart money considers the pricing rich. Biderman doesn’t want to
own stocks like those.

However
quirky Biderman’s theory looks on paper, it works passably well in practice.
The fund is up 96% since it opened its doors in October 2011; over the same
period the S&P 500′s cumulative return is 81%.

Delving
deeper into his theory about what makes Wall Street tick, Biderman describes
assets–commodities or stocks–as chips in a casino. “In every market the house
has an edge over the players, or the market wouldn’t exist,” he says. Commodity
producers, corporate managers and Wall Street underwriters have to be
compensated, or they wouldn’t bother to be in business.

What saves
us, he goes on, is the fact that in a rising economy there is enough money to
make the insiders happy and still leave at least a little something for
ordinary investors. And ordinary investors can improve their odds by watching
what the insiders are doing.

If there’s a
bit of cynicism in Biderman, it could be blamed on the fact that the
67-year-old started his career as a journalist (assistant to Alan Abelson, the
longtime editor of Barron’s). He got a degree at -Harvard Business School,
became a Wall Street analyst and started TrimTabs, a Sausalito, Calif. boutique
research firm for institutions, in 1990.

Biderman
branched into money management late in life. He was just reaching Medicare age
when the Float Shrink fund started taking in money. It now has $138 million.

There is no
shortage of corporations doing buybacks. Standard & Poor’s researcher
Howard Silver-blatt calculates that share repurchases have overtaken dividends
as the principal means by which big companies disburse profits. Shareholders
should be pleased. The switch to buybacks lowers their taxable income.

So corporate
executives who authorize share repurchases are devoted to maximizing the
aftertax wealth of shareholders? A cynic would have an alternative explanation.
Buybacks also boost the value of executive stock options, to which executives
are especially devoted.

Let’s pursue
the cynic’s line of thinking. In a world where any corporation might rationally
replace its quarterly dividend with a buyback program but only some do, what do
buybacks tell us? Perhaps that the insiders at those companies see better
prospects ahead. “It’s not illegal for a company [as opposed to the managers]
to buy back shares on insider information or to sell on inside information if
things are getting worse,” Biderman says.

You can’t
put too much faith in raw share reductions, since corporate treasurers’ timing
is imperfect. Buyback volume was high in 2007, when shares were expensive, then
shrank in the depths of the recession, when shares were cheap.

So Biderman
looks for further evidence that the share repurchases are a sign of strength.
To get in his portfolio a company has to be generating more cash from
operations than it is consuming in capital expenditures, and it can’t be
increasing its ratio of debt to equity. That distinguishes his fund from
PowerShares Buyback Achievers (PKW).

There’s
another refinement. The TrimTabs analysis looks not at shares outstanding but
at the “float,” the count of available shares not held by insiders. If the
company is buying in shares but managers are lightening up their own holdings
just as fast, then Biderman doesn’t want to own it.